Aengus Kelly, CEO of AerCap in conversation with Joe O’Mara, Head of Aviation Finance at KPMG

[MUSIC] Hello and welcome. My name is Joe Omara. I'm the head of aviation finance with KPMG. On behalf of KPMG and airline economics, I'm delighted to be joined by Angus Kelly. Angus is the CEO of Aircap. He's joining us for the purpose of our aviation leaders report for 2025. We're recording this in late November. Angus, thanks as always for joining us. Maybe if we kick off first around airline customer performance, and how you've seen that evolve over the course of 2024. Sure Joe, and thanks very much for having me. airline customer performance is a mixed bag. We've seen declining profit margins from airlines over the course of the year, driven by, I would say, primarily cost inflation. What happened post-COVID is that we had a shortage of skills, particularly pilots. We had it in mechanics, and of course, once pilots get a significant pay rise, particularly like we saw in the United States, where some guys are earning $400 an hour, which when you multiply that out, that's $800,000 a year for driving a bus to all-intensive purposes. And what we found there is when they get that pay rise, that filters through the whole organization, and then it infects the industry. We had one close to home here with their lingus, with the strike, and the industrial unrest with the pilots that led to significant pay rise. That, of course, is what the IAG group were very concerned about, that one of the smaller parts of the entity would get a disproportionate pay rise, would infect the whole of the IAG network, which in turn would have infected all of European aviation. So I understand that labor had to get a pay rise, of course, but it's gone too far. And now we have squeezed profit margins, particularly, I would say, in the US. The majors are able to take a lot of that on board, because they have the long-haul business, which is very lucrative at the moment. But that would be, from my perspective, we've seen it, as I say, declining profit margins in the airlines. But from the less-orous perspective, does that matter, not tremendously, because once they can pay the lease rent, whether they make $100 million or nothing, or lose $100 million, we still get paid the same. And the other thing that's happening with the airlines is on the aircraft side, where we're seeing the unreliability of the new technology manifest itself in a lot more aircraft on the ground. When I say aircraft, there's obviously the physical number of aircraft that you have, like the Pratt and Whitney issue, where we're, I think, 650 aircraft were off around the ground last month. The problem, though, is that when all the engines are functioning, all the new tech, they're not lasting as long on wing. So they're spending more time in the maintenance shed than their predecessors did, which means more time is needed for maintenance costs. You need more aircraft to fly the same number of routes. You have the complexity as well that happens because they don't have enough air for the new technology aircraft. They're hanging on to older aircraft for much longer, and that will continue to be the case for years to come. But that means you're operating dual fleets. And dual fleets are inefficient. When you look at the aircraft or the airline business, there's massive operating leverage. So that means you want commonality of everything from toothpicks to jet engines. When you don't have that commonality that adds extra cost, be it true, you've got different seat layouts. So on your booking systems, they're different. They're not the same. You have different pilot training, different spares, different aircraft, all that adds to inefficiency in the system. So they're the things to me that are pulling back airline profitability. Demand is still good. Demand is still strong. But would you, as you sit here maybe in late 24 versus maybe where you would have been 12 months ago when we spoke and you think about airline performance going into 25, are you concerned around those inflationary or operational challenges? Or as you say, it's a large less sore. You think demand, the environment is so robust that he's not going to impact on your business. No, I don't see it impacting our business because the aid demand is robust but crucially supply. Supply is restrained and will continue to be restrained for years to come. You know, we know that, we can see it on what's happening in the manufacturing side. We can see it on the engine side. We can see it in airline activity where the biggest buyer of used aircraft in the world today is airlines where the biggest buyer is airlines of older aircraft because they know the shortage of aircraft is going to go on for years to come. If we just look at deliveries coming out of Seattle or Toulouse, Seattle is obviously well known but Toulouse as well was announced again last week by Guillaume that it'll be a very tough, I think I remember the exact words, but a big ask to hit the delivery targets they have which we're already taking down from earlier in the year. And I would say that trend will continue over the years to come. We'd be very confident at will actually. And maybe move on to that OEM side. You know, you're obviously one of if not the largest order of aircraft in the world. How do you view that supply side shortage? So in one element presumably it's helping push up asset values or lease rates to that supply demand in balance. But at the other end how hard is it from a business planning perspective when you expected to receive X amount of Max's or NEO's during the year and you're not getting them? The biggest problem is with customers. For us, okay it's frustrating, you don't have the growth in your business that you're predicting. You're holding onto capital that you had set aside for investing in new assets and it's not coming. And that costs but the biggest issue by far is on the airlines because they are planning for a new aircraft or a bunch of new aircraft a year 18 months out. They've hired the crews. You think that you're hiring pilots at $3,000, $400,000 a pop. You expect to get six airplanes for next summer if you say whatever airline it is. I know it was one in Europe. This happened to last year as a customer. They'd hired the pilots. The airplanes didn't show and they were stuck with the costs. They'd hired the cabin crew. They'd sold the tickets. They had to go into the wet leasing market. They had to contract at very high rates from wetless ores. So these are the real costs that are happening for the airlines. The same occurs you've seen in the news of course with Rolls Royce recently of airlines like Virgin Atlantic and British Airways having to cut schedules. That's due to the fact that the engines aren't lasting as long on wing as I said before. So these are the things that are much bigger impact than it is for us. For us it is it's not an insignificant cost to be holding onto two billion dollars that we can't deploy that we may have raised already in the capital markets. If you looked at then, again, keeping with the OEMs for a moment, what can they improve? It's two questions. One, how and when do you see it on Corking? So did they get back to normal or reasonable supply side levels? And two, how have you found them from a communication perspective? I don't find it. I mean communication, they tell you the bad news. I'm saying they're not hiding it on a robust show. So there's no issue there. They tend to tell you as soon as they know. The problem is sometimes they don't know themselves until quite late in the day. So I wouldn't be too critical of them there. I do believe the technology, the key is not delivery. The key is the technology that the technology has to become more robust. Because there's no point delivering engines aircraft into the system if they're not durable. If they're going to be coming off wing much faster than the operators expect, then even though they may have delivered the aircraft, they won't actually last as long in service, which is extraordinarily frustrating for the carrier. When they might have a $60 million asset, $150 million asset, and all these associated costs with crews, ground handling maintenance, the goal with that, that isn't operating at the levels they wanted to. So in an ideal world, the technology would mature faster. I don't see that happening. I think we're going to be in a situation where towards the end of the decade, they may well get to the production levels they want. But I think the road is probably longer on the durability of the technology, and that's going to keep the demand for used aircraft extremely strong for years to come. Because it's more durable. And then maybe if you move on to lease rates and what you're seeing. So lease rates, factor demand environment, factor of interest rates, can you talk to us about how lease rates have evolved over the course of the year, and just where you see that going into next year? I've gone up a fair bit, you know, beyond the rate of interest rate rises, which is always important. I don't see that changing. I manifest itself of course in lease rates. It manifests itself in aircraft values in what we're selling them at. So I would expect to see lease rates maintain at these levels. I've not clipped up a little bit, depending on interest rates. And feeding in then to lease extensions, and the approach you're seeing presumably airlines are coming to you a lot earlier. In relation to lease extensions, and Kate talked to us maybe about how your extension rate has evolved, and just how earlier are airlines engaging in relation? That's a fair point because obviously from our perspective, what's important is not just the lease rate. It's the term no downtime, no transition costs, which are very significant. And so if you can get a good lease rate extension, no downtime, no contribution to cabin overhauls, and good maintenance rates and return conditions, you're going to do very well. At least it's just one component of those four. So people get too fixated on lease rates. If you're extending an older aircraft, for sure the maintenance cash flows will be much bigger than the lease rate cash flows. There's no question about that. If you're on a 16, 18 year old aircraft, if you get full maintenance rates, it'll be higher than the monthly lease rates. Now, from our perspective, as I said, we're gonna continue to see pretty strong demand there, if we go across the board. - And then maybe in relation to the trading environment, you mentioned that you've probably an increase in airlines looking to buy assets, right, older assets to keep their hands on it. But as you assess the overall trading environment, having these conversations where people a year ago was kind of stodgy, right? There wasn't, trading was nowhere near it was, maybe pre-COVID levels. Have you seen that up tick? And what are you seeing from an asset value perspective? - Well, asset values are definitely higher. I mean, that's evident from the margins that we are printing. So there's no doubt asset values are materially higher. At least rates are materially higher too. So they go hand in hand. In terms of the buyers, strategic buyers will always squeeze out, if an airline wants to buy, it's just worth more to them than a financial investor. And what we have seen, as I said, is over half our aircraft sales going to airlines. And we're the biggest seller of used aircraft in the world. That's reflective of the market. - And how is that comparing, is maybe to, if we put a lens of pre-COVID on it? - 20%. - Okay, so more than that. - More than that, right? - Yeah. - And then what's also happening is, some airlines aren't buying, but what they're doing is extending very long term with, you know, that they're what the option that to buy at the maintenance condition at the end, so that they can say, all right, well, I'm extending for five years. It's a 20-year-old airplane. And at the end, I don't want to have to refurbish engines. I'll just write you the check for what it would cost to refurbish those engines in hand-of-backed to all intensive purposes. It's the consumption of the remaining economic life of the aircraft, which, you know, there's two sides of the same coin of an aircraft sale. And if you put those in, 'cause our extension race is running it, I think it was the highest ever in the last quarter at 90, 95% of these expiries were extended. So that just tells you everything you need to know. All the airlines believe, Boeing and Airbus, they're not gonna deliver the airplanes, even if they do, the engines won't stay in the air. It's not just the engines to be fair. In some aircraft, there's landing gear issues, there's avionics issues. And so they know they need to hold on to those older aircraft from much longer. - When you look at that from an aircraft perspective, obviously, scale gives you a significant advantage. You know, obviously the engine business presumably does too. Would you view that as a differentiator as you're going across the market? - Sure, we would, of course. I mean, look, when the world is tight of engines, and we're the biggest owner of spare engines in the world, it does help, we can help our customers more than any other less sore. No one else can say, well, look, if you're really stuck, we can get, we can probably, can't say we can always get you an engine, but there's a good chance with us, there's no chance with others. - And maybe moving on to the liability side of the balance sheet, maybe we'll start with interest rates. Last year we were to talk about a higher for longer period, the Whiplash rate rises 22 to 23. We're slowly starting to see a decrease. Given you guys, and you've talked about running that hedge book, does the interest rate movements or fluctuation have a significant impact on the business either in the short term or medium term? - No, it shouldn't, well-run business, it shouldn't. So from our perspective, you see the stability of our returns over 20 years, they don't move around that much, because that's what I meant with the core business. They don't really move around that much. What you will have is a movement where we'll have the duration, I should say, sorry, we'll have the duration of our asset book. So the duration of our lease, this might be six and a half, seven years, and the liabilities are almost the same, six and a half, seven years. So you'll have the same quantum of assets and debt repricing in a given year. Where, of course, you get into a lot of trouble is if you were funding short term over the last five years, and you're having to reprice your debt in this market, and your leases aren't repricing, because you went long and 12 year leases. That's where some leasing companies have obviously tripped up, and that's hurting their profits, but that's something Eric Happers never done. - And maybe looking more broadly at the aviation debt market, you obviously have the investment great status and the top the unsecured bond market, but you're overall assessment of the debt options that are available to aviation finance and the health of that market. It's very robust, because coal would prove once again that aircraft are a good investment. It's a hard asset, a dollar asset, a well-maintained one will be in demand. There could be periods of very strong demand, and it's worth a lot, but even in periods of lower demand, you'll always place a well-maintained aircraft. You may not get the rate you want, but it's a good store of value. So we have seen very sticky pools of capital one to back this industry in very large size around the world. I think we alone have 22 banks in Taiwan as an example that lend to us. Obviously loads in Japan, Europe, the US, et cetera, as people have understood the asset class a lot better. So we would see a very significant demand from the lending. So I have that reflex itself. I think this morning our five-year unsecured spread is HC 84, 85 basis points over treasuries. And again, I'm going to put a total lens in a five-year, but you go pre-COVID, post-COVID. You guys went out and raised huge amounts of unscrupely funding the G-Cast acquisition. As you return to that market, are you seeing some payback? And what I'm sure was an education process you've done across the investors into those bonds? Yeah, I mean, certainly, because we were moving the industry to a different level when we both the G-Cast business. And we had made a very significant effort on investor relations on the debt side, of course, but also on the equity side, because we were bringing a lot more equity into the market than it had ever been brought in before. And there was a very significant investor outreach there. That's ongoing every day. That was a mistake we made. I'd say after we bought ILSC as AIG was the main shareholder and was looking to sell and was selling at stock. And I don't think we'd realized the impact of a lot of stock going into a market that wasn't that deep. And that created a lot of volatility in the stock price. This go around. We learned those lessons and a very significant amount of work went into teaching equity investors, in particular, about the sector. The debt guys were already there, because there's so much issuance of debt every year. So that was the main learning, I would say. And that's worked out very well. Yeah, and it gets to pro with that little bit. So you look at the share price performing very strongly over the course of '24. Is it that piece that's around eyeballs and education, if you think maybe your own investor day in New York? Are you just seeing a greater population of eyeballs on air cap in the wider sector as well? For sure. I mean, look, because of air cap size, it's brought a lot more eyeballs into the sector. And that's critical. You just have to get people to look at the sector. I mean, it's not easy to get guys to look at a new sector. If you're an investment fund, you have thousands of companies you can invest in. And in the equity side in particular, in very niche sector of equity investment, particularly public equity companies, you do need to work hard to get the eyeballs on the sector to educate them, to show them the stability of returns, that our returns have nothing in common with airline equity returns. And in fact, not much in common with the industrials were far more stable return on equity than either the industrials in our space, like the bowings or air buses, or the customer base. And if you look, maybe at that population investors and that increased population investors that are looking at air cap, are there interesting trends in the nature of investors? Are we seeing institutional capital, private equity? Do you have a handle on maybe what that underlying investor class breaks out into? Well, it's all institution. I mean, we don't have any private equity in our shareholder base. Our private equity, of course, is investing in other platforms in the industry, which is great too, because they also realize the stability of the asset value. But in our space, I mean, we would have had, to be fair, as I said, a mistake we made in 2015, 2016, there was a load of hedge funds in the stock because we hadn't educated an investor base. We learned our lesson there, and over the last four years, then the real effort is you may getting long institutional, long only institutional investors into the stock. And that's worked very well. And maybe another element of the capital markets, we see is the ABS market. We've seen some life return to that market over the last few months. How important a tool do you think that is? Maybe for the wider aviation finance piece. I mean, you guys aren't going to use that as a debt tool, I appreciate, but might become an interesting trading tool in time. Oh, I think it's a great spot, the ABS market. We'd very much like it to come back. No, one of our predecessor companies. I worked on the first ABS ever and the biggest one ever done. So no, I would be a big fan of the ABS market. And I certainly think it offers tremendous value at the spreads we see today. I think where you can buy fairly modestly levered you. your notes, be they the bees or seas, at the spreads you're getting. I think on a relative basis for a bond investor, with a good manager on board, I think that offers great value when I look around the world at other spreads. Now, it's not the most liquid thing in the world, so the bid and the ask might be wide if you have to shift it, but if you can buy and hold, I think that's a very attractive bond with a well-managed vehicle for investors. And maybe bring into the macro leasing environment, the first question is maybe in that least percentage, which we've consistently spoken about and we saw less or is funding probably near 60% of new deliveries post-COVID, whether that was large guys like yourself on the order book side or saying on the lease back market and another player is stepping in. Do you think that's kind of where it's top and out, it will continue to see a natural trend upwards, we definitely breached 50 now, do we still continue to see it step upwards or the end up in a world maybe where the OEMs retrench a little bit apart from maybe large less sores, what's your perspective on that? No, the OEMs are torn between fear and greed, they're schizophrenic. And so when someone walks in and says I'll pay 15 million more in airplane, they're going to take us. Now they know that they may only deliver a fraction of what the fellow orders, but they'll go for a bit of it, but generally I mean I think to be fair, they don't want to get stuck with Mickey Mouse leasing businesses for significant parts of their backlog. The backlog as they said, they have a junk bond credit, customer base, the OEMs. So 95% of the world's airlines are junk bond credits, the OEM say to themselves, how can we have a massive fixed cost base with a big junk bond customer base? Well we can't stop production, it's extraordinarily costly to do that. We can't just easily move one aircraft from customer aid to customer B, that's a very time consuming process just to get seats today would be a year. So what do they do? They have to make sure that the backlog is anchored among some high-quality customers. And that's where the big less or the guys as Guillaume Foret call us, the shock absorbers, the high investment grade less or so, they know they can build an order book around and a few airlines that would fall into the same category. Then they can be more speculative when dealing with smaller guys, both airlines and less ors to be fair. To bring it, maybe in looking leasing and the importance of scale or potentially the increasing importance of scale. If you look at maybe yourselves as the outliers, the supersize less or and then a bunch of very large investment grade players, having some of these conversations, they think in as well, we'll do we end up in a world where there are four or five extremely large leasing groups. Maybe they grow in organically, maybe they're the only ones to get an order book, but that you have a contraction at that very top level with really, really large players. Everyone else playing in niches or it might be secondary market or trying to find something that works. Is that a theory you'd agree with? Or do you think we'll still see a world where we have 10, 12 large medium sized players? I'd like to see the former. I don't think it'll happen, unfortunately. We would like to see consolidation. I think the reason is that the owners of those businesses know that they throw off very steady stable returns. And unless they have some event in their own business that forces a sale of what they maybe a non-coar asset, I don't think it'll happen. If we look in the past, the most recent one, Standard Chartered had a very good business. It sold at a good premium to book. But Standard Chartered went into an order to sell it because it was a very stable returning business. The same happened with GE, with DialFC. I mean, as evidence by their actions afterwards, they had to sell the businesses. But they knew that it was a very good business. They hold on to a lot of stock because they know that there's long-term value. So I think you need catalysts to make that happen. Another example of that, that hopefully we will see more consolidation. But I think it'll be because of what's happening with the parent entities. I can't see those parent entities. We haven't seen it in the past, voluntarily offloading these assets that are very stable. But the barriers to success are enormous. So we buy an airplane, funding costs, who wants to deal with us not many? Okay, we might get it at some rate. We go to an airline. There's like who are you? Someone tells us we hear there's demand in India. We don't have any presence in India. You don't know anyone there. Okay, how do we get there? Do we have to hire a broker? We go to an MRO shop to get the airplane ready. The MRO shops says who are you? We have no interest in dealing with you. We'll come back to you in a year's time. That's what's happening for the smaller guys. They just don't have relevance to the MRO network. They don't have, like forget about orders, like that's bunker stuff. They don't have relevance to a seat manufacturer. They can't get an airplane. They have to transition. They're lucky today that there's lots of extensions. But if they had to buy seats, no one would, I'd say the odds of getting a ship set of seats that are non-standard for a small less or zero. And if you maybe put on their couplines or not, you've typically been opportunistic on that M&A you've done. You think back to Genesis, Silas, CG, has. It's been in opportunities you say where you potentially have a seller that needs to exit or you have a market that's in a downturn. In this market at the moment, do you think there will be more M&A opportunities that are out there or do you think you probably need some external factors to drive that type of opportunity? Well, the cheapest deal out there is our stock because we've bought massive companies at big discounts. If we can buy ourselves, that's buying us at even a very significant cream to book. It's like buying some other less source that were brought together by M&A at a 30% discount to book. I think we'd have to see value. It's not there for us at the moment. We'd see the best value in our own business. And we've contracted a lot of organic growth actually during the year as well. We did very large engine transactions this year. We did large sale leasebacks this year. So, I don't think on the M&A front the opportunity is there for value at the moment. But if it was, when we thought there was good value for sure, we would. So, just in closing Angus and thanks as always for your time and insights, but as you look out into 2025, what are your optimism levels like? Pretty good, you know, as I said. Look, we know, if you're surmising things, capital markets are there, supply issues from the OEMs are very constrained right now. The MRO network is very constrained. And then we see airline profitability and airline, importantly airline operating and cash for a weekening a bit, which is positive for us. It means, of course, that they'll need the less sores more and more. So, I'd be pretty optimistic about 25. On that hopeful note, on behalf of KPMG and airline economics, I'd like to thank you for your time and insights again and wish you an air cap a very successful 2025. Thanks so much, Joe. Thank you very much today.